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November 26, 2012

Planning for Disaster: Using Behavioral Finance to Shape Strategy

Understanding how clients react to disasters like Hurricane Sandy is an important part of financial planning

View of a collapsed house along the central Jersey Shore after Sandy. (Photo: AP)

In the aftermath of Hurricane Sandy’s vast destruction, financial advisors across the country may be experiencing a sudden rush of clients pouring into their offices, eager to revisit their financial plans and make sure they are in the best possible shape.

This is only to be expected, said Barbara Friedberg, a professor of finance at Santa Clara University in California who also manages money privately for some clients, since most investors don’t really account for force majeure. When events like Sandy happen, people go into a tailspin.

Sure, thoughts of cataclysmic events do crop up every now and then, and there are some who worry about these things more than others. However, as a general rule, very few individuals factor the unexpected into their financial thinking and planning, Friedberg said, because the human brain resists change, and “people are slow to update their beliefs to new evidence.”

Weather services had been warning about the dangers of Sandy for days before the hurricane hit the East Coast, but nevertheless, there were many who didn’t heed the warnings: people who said, “We never lose power so we won’t lose power now,” Friedberg said.

That mindset extends to financial planning, she explained, manifesting itself as a “conservatism bias” in behavioral parlance, meaning that very few people account for the impacts of natural disasters on investment portfolios and financial plans.

If and when these events occur, there’s no doubt that their effects can be disastrous. But when they do take place, these force majeure events also result in investors acting out of complete panic in a manner that can sometimes be quite irrational.

“Investors also manifest another behavioral bias known as forecasting error, where they give too much weight to recent events,” Friedberg said. “People go from thinking ‘that kind of thing can never happen to us’ to feeling completely distressed and out of control, believing then that we’ll just have more unexpected events of the same magnitude.”

Whether or not Hurricane Sandy served to add fuel to the argument put forth by a growing number of scientists that global climatic change will only engender more ferociously unpredictable weather phenomena, Friedberg believes that it’s up to investment advisors to see this period as an opportunity to create balance between conservatism and forecasting error.

Financial advisors have a good opportunity now to educate their clients as to the importance of extensive financial planning, Friedberg said.

“After a catastrophic event of this nature, people really wake up as there’s a sense of urgency that comes about,” she said. That offers advisors the perfect platform from which to talk about such products as natural disaster insurance, which many investors may otherwise brush off.

More importantly, it also creates an opportunity to thoroughly revise a financial plan, making sure that all legal documents clients need for their working lives as well as their retired lives – including estate planning and legacy documents -- are in place and up to date. The strength of natural disasters like Hurricane Sandy cannot be quantified and could result even in the loss of life.

It may seem that events like Sandy are happening more frequently than they used to, so this is a good time for advisors to take advantage of their clients’ frenzied mindsets by having them think more about the unthinkable, while ensuring that they still remain rational in that thinking, Friedberg said.

“There is an urgency that comes about after events like Sandy, and once people have either experienced loss or seen loss, they start to want to plan for it,” she said.